Chapter 2
Financial Statements, Taxes, and
Cash Flow
Key Concepts and Skills
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Know the difference between book
value and market value
Know the difference between
accounting income and cash flow
Know the difference between average
and marginal tax rates
Know how to determine a firm’s cash
flow from its financial statements
Chapter Outline
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The Balance Sheet
The Income Statement
Taxes
Cash Flow!
The Balance Sheet
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The balance sheet is a snapshot of the firm’s
assets and liabilities at a given point in time
Assets are listed in order of liquidity with the
most liquid assets being listed first
Liquidity is the ease with which an asset can
be converted to cash without significant loss
in value
Inventory is the least liquid current asset
The Balance Sheet
(continued)
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The balance sheet equation
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Assets = Liabilities + Stockholders’ Equity
Assets = Liabilities + Owners’ Equity
Net Working Capital
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Net working capital = Current assets –
current liabilities
NWC = CA – CL
Net working capital is positive when
current assets exceed current liabilities
Net working capital is usually positive in
a healthy firm
Market Value vs. Book Value
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Assets are reported on the balance sheet at
book value
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Historical cost, what the firm paid for the assets
Required by GAAP
Market value is the price at which the assets,
liabilities, or equity can be bought or sold
Market value and book value often differ
Income Statement
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The income statement is a view of the firm’s
operations over a period of time
Revenues are reported when accrued,
Expenses are reported when incurred
Matching Principle: GAAP requires revenues
to be reported when accrued and matched to
the expenses incurred to generate the
revenues
Revenue – Expenses = Income
Taxes
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Life has two certainties: Death and
Taxes
Taxes and tax law are always changing
Taxes (continued)
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Marginal versus average tax rates
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Marginal: the tax rate paid on the next
dollar earned
Average: Total taxes paid divided by total
taxable income
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Total taxes paid/total taxable income
Cash Flow
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Cash flow: The difference between the
amount of money that came in and the
amount of money that went out
Cash flow is one of the most important pieces
of information that a financial manager can
derive from financial statements
The standard financial accounting Statement
of Cash Flows addresses a different issue
than what we are concerned with
Cash Flow (continued)
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Cash Flow From Assets (CFFA) = Cash
Flow to Creditors plus Cash Flow to
Stockholders
Cash Flow From Assets = Operating
Cash Flow – Net Capital Spending –
Changes in Net Working Capital
Operating Cash Flow
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Operating Cash Flow is the cash flow
that results from the firm’s day-to-day
activities of producing and selling
Expenses associated with the financing
of assets are not included since they
are not operating expenses
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Example: Interest expense
Operating Cash Flow
(continued)
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Formula:
Operating Cash Flow = EBIT +
depreciation - taxes
Net Capital Spending
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Net Capital Spending: Money spent on
fixed assets less money received from
the sale of fixed assets
Formula: Ending net fixed assets minus
beginning net fixed assets plus
depreciation = Net investment in fixed
assets
Change in Net Working Capital
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To determine the change in net working
capital, take the difference between the
beginning and ending net working
capital (NWC) figures
Ending NWC minus Beginning NWC =
Change in NWC
Cash flow to creditors
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A firm’s interest payments to creditors
less net new borrowings
Also known as cash flow to bondholders
Interest paid – net new borrowing =
cash flow to creditors
Cash flow to stockholders
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Cash flow to stockholders is dividends
paid out by a firm less net new equity
raised
Dividends paid - net new equity raised
= Cash flow to stockholders
Quiz
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What is liquidity and why is it important?
What is the least liquid current asset?
What is the difference between market value
and book value? Which should we use for
decision making purposes?
What is the income statement equation?
What is the difference between a marginal
and an average tax rate?
Quiz (continued)
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What is the Operating Cash Flow
equation? Why do we add back
depreciation?
Why is interest paid not a component of
operating cash flow?